Sunday, 25 November 2007

The harsh world of small-time property speculation

It must be difficult being a buy to let investor these days. In October, house prices fell right across the country. Even in London, perhaps the most overvalued housing market in the world, prices started to return to Earth.

A belief in continued house appreciation is what drives the buy to let investor. It is this belief that pushes them into the real estate agency, to buy up those inner city slums, and then down to the bank to take out a mortgage. The idea that property keeps growing at 10 percent a year clouds other financial considerations.

The buy to let investor rarely gives any serious consideration to rental yields. Today, in most UK cities, rental yields are between three and four percent, which is approximately half of the rental costs of money - the interest-rate on a mortgage. The only way that a buy to let investment to make sense is if one expects house prices to appreciate sufficiently to recoup the a) differential between rental yields and interest rates; b) the rate of inflation, c) any other extraneous costs that comes from renting to unreliable tenants, such as the tenants skipping off and not paying the rent.

The low rental yields means that any buy-to-let investor, dipping into the market today, must come with deep pockets. They have to be prepared to offer a considerable subsidy to any tenants fortunate enough to take up the newly purchased house.

Unfortunately, there is no prospect of pushing up rental yields. The supply of rental properties is to say the least, healthy. In any event, renting has this wonderful flexibility. When the landlord tries to squeeze the tenants for more rent, the tenants simply has to move and that 3 percent rental yield crashes down to zero. In other words, buy to let landlords need tenants more than tenants need landlords.

During the early months of this year, there were plenty of investors prepared to make huge sacrifices on behalf of their tenants. Around one in four mortgages were taken out by these generous and selfless souls.

However, will this generosity continue when house prices really start to tumble? Almost certainly not. As these cash flow problems grow, and it becomes increasingly clear that the losses cannot be recouped with future appreciation, then it becomes a matter of racing to the exit. A new principle will emerge; the quicker a buy-to-let investor gets out, the lower the losses.

In some respects, the UK housing market is entering uncharted territory. The market is now dominated by small-time property speculators, who have misjudged financial returns, and who are starting to lose serious amounts of money. There is nothing like hard and immediate financial losses to clear the fog. Buy-to-let investors will learn that it is rental yields and not appreciation that matter. As this lession is learnt, panic will take hold, housing inventory will increase, and prices will tumble.

3 comments:

For me, a real difficulty in predicting the market is that we don't have much clue what the impact of BTL owners will be. I could forsee the marginal BTL buyer exiting the market, but will people really sell up unless forced?

In a slowing market can the average BTL'r afford to give notice to their tenants, refurbish the property (BTL type places with tenants in-situ tend to be difficult to dispose of), and wait for a sale? Anyone have any theories?